Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. As with many other companies Etherstack plc (ASX:ESK) makes use of debt. But is this debt a concern to shareholders?
When Is Debt A Problem?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Etherstack's Debt?
As you can see below, Etherstack had US$1.97m of debt, at December 2018, which is about the same the year before. You can click the chart for greater detail. However, it also had US$51.0k in cash, and so its net debt is US$1.92m.
How Strong Is Etherstack's Balance Sheet?
According to the last reported balance sheet, Etherstack had liabilities of US$6.57m due within 12 months, and liabilities of US$200.0k due beyond 12 months. Offsetting this, it had US$51.0k in cash and US$2.72m in receivables that were due within 12 months. So it has liabilities totalling US$4.00m more than its cash and near-term receivables, combined.
While this might seem like a lot, it is not so bad since Etherstack has a market capitalization of US$16.9m, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.
We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
Weak interest cover of 0.11 times and a disturbingly high net debt to EBITDA ratio of 12.4 hit our confidence in Etherstack like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. One redeeming factor for Etherstack is that it turned last year's EBIT loss into a gain of US$23k, over the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But it is Etherstack's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Happily for any shareholders, Etherstack actually produced more free cash flow than EBIT over the last year. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
We weren't impressed with Etherstack's net debt to EBITDA, and its interest cover made us cautious. But like a ballerina ending on a perfect pirouette, it has not trouble converting EBIT to free cash flow. Looking at all this data makes us feel a little cautious about Etherstack's debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. Over time, share prices tend to follow earnings per share, so if you're interested in Etherstack, you may well want to click here to check an interactive graph of its earnings per share history.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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